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By Shannon Zimmerman | 06-10-2011 12:21 PM

Hancock: Momentum Works Because It Hurts

The high pain points of a momentum strategy have kept its upside from being arbitraged away, says GMO's Tom Hancock.

Shannon Zimmerman: For Morningstar, I'm Shannon Zimmerman.

I'm joined today by Dr. Tom Hancock of GMO. Tom is the Co-Head of Quantitative Equity Research at GMO and manages international portfolios as well.

Tom, thanks for being with us today.

Thomas Hancock: Thank you. My pleasure.

Zimmerman: Tom is here at the Morningstar Investment Conference, and we've just finished up what I thought was a terrific panel discussion with John Montgomery of Bridgeway and Doug Ramsey of Leuthold about price momentum, and you've done a great deal of research into this persistent effect over the course of many, many decades. It seems to be the case that a simple strategy of just investing in the stocks that are performing the best over the last 12 months significantly outperforms.

And you've put together a lot of research in the paper called, "A Contrarian Case for Following the Herd," which is available on the GMO website, and I think it's a terrific and very accessible paper, both for folks who know about momentum and those who just want to learn about it. But we can learn something now. Tell us a little bit about why something that is as simple as a price-momentum strategy hasn't been arbitraged away?

Hancock: I think the main reason for that is it's just a very painful strategy to run, and the bulk of assets in this world are managed indirectly--people like me or organizations like ours managing money for clients--and when you're using a price-momentum strategy you're basically buying stocks that go up, and hoping they go up some more, but if they don't, they go down, you sell them and buy the other ones that went up instead.

So, the situation in which you lose is you've just bought stuff that's gone up, then it goes down, and then you sell it, and that just makes you look like an idiot, right? It's a very uncomfortable thing to do, and frankly, for most professional investors, it's a very unintuitive thing to do, because most of us are kind of naturally born and bred contrarians. We at GMO believe very much in contrarian value-based investing.

So, the pain point for momentum is so high that when you see these drawdowns as you saw, for example, coming out the market bottom in 2009, when momentum underperformed, the wipeouts are just too painful. So, there's a limit to the arbitrage there and people can't exploit it, at least can't exploit it completely so it disappears.

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